Simon Wren Lewis on central bank independence

Simon is a member of Jeremy Corbyn’s economic advisory team, and participating in a review commissioned by John McDonnell on the Bank of England’s mandate.

So the fact that he sees fit to pose the question ‘can central banks make 3 major mistakes in a row and stay independent’ is significant.   That is, you are interested in forming a view about what kind of economic platform Labour will run on if Corbyn survives in post as Labour leader until the 2020 election.

It’s clear that Simon thinks the case for central bank independence is for many, moot, though he himself is in favour.

He writes:  ‘I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this.’  We are left presuming that these ‘non-economists’ are those whose team he joined in Corbyn’s Labour Party.

Simon’s blog has the Bank of England charged with making 3 ‘mistakes’, the corollary of which is that perhaps the central bank should no longer be independent.

I don’t think Simon makes a case that is at all persuasive.

In short, as I tweeted earlier, I think that it’s highly contestable whether the mistakes Simon identifies were indeed mistakes.  And even if they were, it does not follow that central banks should have their independence curtailed.

Independence was introduced to shield monetary and financial policy the pressures of short-run electoral expediency.  Removing independence removes this shield, for no gain in terms of avoiding future ‘mistakes’.

Mistake 1 is that the Bank of England failed to foresee the financial crisis.  There is certainly truth to this, though the Bank is wont to point to repeated warnings in BoE-ease in its Quarterly Bulletins, and other vehicles, in the run-up to 2008.

But, taking this lack of foresight to be true, most of the economics profession failed in the same way.  One or two notables (my favourite being Rajan’s Jackson Hole speech) did not, and made intelligible, reasoned and prescient interventions.  Many of those who, ex post, look like they saw it all coming, did not, and as Noah Smith and others have commented, can be dismissed.

In the UK, we can take it that the bulk of the UK establishment, including the Treasury, likewise failed to foresee what was happening, because they did not intervene to alter the regulatory stance and framework in the way that was begun once the failings became known.  So, if we had run a counterfactual history in which the Bank of England had simply enacted whatever the Treasury had asked for, I don’t see that the instrument settings, or the legislation, would have turned out any different.

Are there memos lurking somewhere in which past Chancellors were urging higher interest rates or more punitive regulatory stances?  I doubt it.  [Note that anyway I would suggest that it would have been damaging and futile to try to head off the financial crisis with tighter monetary policy].

Mistake 2 was that the Bank of England did not protest sufficiently about the tightness of fiscal policy imposed by the Coalition government post May 2010.

Assume for a moment that the BoE should have protested.  Do we think that a monetary policy body that was not independent would do any better?  The Coalition did what they did because they thought it was the right or expedient thing to do.  Would they have been swayed by private advice by civil servants?  Would that advice be any more likely to be forthcoming?  I doubt it.  So it does not follow, in my view that mistake 2 is a case against independence.

However, I think it’s contestable whether there was a mistake at all.

I take the view that, initially, Coalition fiscal policy [at least its aggregate stance] was perfectly reasonable, until it had become clear that the UK was not to be put in the same basket as the other troubled sovereigns.  Subsequently, on risk management grounds, looser policy might have been preferable, but not [ex ante] to generate higher demand, but to provide for tighter monetary policy which could have allowed for future cuts if needed.  The large and protracted undershoot of the inflation target subsequently looks like a bad mistake, but, ex ante, the case – made by the BoE – that this was largely due to surprises about the extent and persistence of the pass through of Sterling, and weak commodity prices, seems fair enough to me.

Further, even if the Bank had disapproved of Coalition fiscal policy, speaking out against it could have undermined the efficacy of monetary policy in the future.  Without a specific commission to do so in its mandate, there would be the risk that future MPC members would be selected for their favourable stance toward the Government in general.

What might follow, if you accept that there was a mistake number 2, is that the mandate should be amended to provide for explicit comments from it on whether its ability to meet the inflation target was being hampered by government fiscal policy.

Mistake number 3 is that the Bank of England has been too pessimistic about the supply side of the economy, setting correspondingly too-tight monetary policy.  I have dealt with this partly in my response to mistake number 2.  But a few more remarks.

First, the 0.5 floor was not set, initially, as a matter of monetary policy conservatism, but because it was judged that cutting rates below that floor would not be stimulative [because of the difficulties it would cause for bank balance sheets].  This view about the floor to rates was amended back in March 2015.  So the charge that this floor signifies conservatism applies only since then.

Second, there is the implication that the BoE did not apprehend that potential output was itself a function of the level of demand, and thus its own policy stance.  In fact, it did, right from the off, during the crisis, and this possibility – it surely has to remain just that – was mentioned frequently in its communications, and discussed at length in private.

Third, would rolling back independence cure monetary policy of ‘supply-side pessimism’?  I doubt it.  If it did, would we get better policy?  Or would we get an optimism/pessimism that was a function of the electoral cycle?  Simon clearly wants looser policy now, and so a bit more supply side optimism would do it for him.  But would that be helpful in a few years, when monetary policy is no longer at risk of being constrained?

Simon’s mistake number 3 actually contains what I would classify as a separate mistake number 4, the failure to appreciate that, in the vicinity of the zero bound, the best way to hit the inflation target, on average, is to contemplate and engineer an overshoot.  I think Simon is largely right on this.  There are dissenting voices in the Fed – notably Charles Evans.  But none in the BoE’s MPC.  I don’t think it follows that rolling back central bank independence is a good idea.  Since many economists dispute that the overshooting policy would be a good idea, one presumably would have monetary policy informed by the same spread of views inside the Treasury, or a subservient BoE.  At the zero bound, one could reap the benefits of ‘boom=good’ that would occur to the politicians, but away from it, this would be harmful.  Much better to clarify what’s anticipated in the mandate, at the zero bound.  And not to reappoint those who take what you think is the wrong view of the matter.

All this said, I do think it’s fair enough to debate the merits of independence.  Given the huge and varied powers now vested in the Bank, and the intractability of the problem of providing it with adequate formal scrutiny, one should probably err on the side of over-debating it.

For that reason, even though I am not convinced by Simon’s arguments, it’s to be welcomed that they are out there.

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10 Responses to Simon Wren Lewis on central bank independence

  1. Lyn Eynon says:

    On your comment that “Coalition fiscal policy … was perfectly reasonable, until it had become clear that the UK was not to be put in the same basket as the other troubled sovereigns”, which other sovereigns are you referring to? The UK never saw an interest rate spike or any other sign that markets considered default a risk; nor did the US, nor Canada, nor Japan. The Eurozone countries don’t count as they had already surrendered monetary sovereignty.

  2. Lyn Eynon says:

    “Independence was introduced to shield monetary and financial policy from the pressures of short-run electoral expediency.” Sometimes expediency – and the urgency that goes with it – is exactly what is needed. Better Roosevelt than Hoover.

  3. Lyn Eynon says:

    Let me make the case that potential output is a function of the level of demand. A negative demand shock – from the credit contraction following the financial crisis, sustained by austerity – reduces demand for labour. Where the supply of labour is relatively inelastic, as it has proved to be in the UK, this puts downward pressure on real wages and hence on marginal productivity as businesses find it profitable to substitute labour (hand car washes) or to employ over-qualified staff (post-grad waiters). The result is that resources are employed but less productive than they might be. Over time, this negative impact on productivity is reinforced through hysteresis and low investment.

    In these circumstances, a demand boost would put upward pressure on wages, which is just what is needed to release workers from low productivity activity to take up more productive opportunities made available by the increased demand. Such an inflationary stimulus would increase potential output while resources are under-utilised.

    • Tony Yates says:

      The classic channel is that workers lose skills and attachment to the labour market and suffer mental health impairment, and this reduces the amount of effective labour supply subsequently. Not forever, but perhaps as long as a generation.

  4. Vince Richardson says:

    Great article,thank you for having this debate.I would say the BoE does not have enough independence.It has to stick to a universally agreed 2% inflation target for sure, set by the Chancellor,but this is a pretty safe target.Given that, the BoE right now needs more tools to get us there,outright money printing for the people(rather than traditional QE) being one of several options mooted by the likes of Corbyn himself.I favour the Sovereign Money proposals put forward by the Positivemoney organisation who have done a lot of work on this matter.

    I very much agree with you when you mention government “hampering” BoE policy.We had a situation where the central bank wanted to implement expansionary measures whilst the government is wanting to carry out deflationary measures,it would be helpful if they were both pulling in the same direction at the same time.Maybe that is an argument for less independence,but my view is the BoE has been correct here and the governmnet not.

    So all in all we need an a far more indendendent,robust and transparent central bank.One that can stand up for ordinary citizens when the crunch comes, not just the private banking sector.

  5. The claim that the BoE was correct to worry about the confidence fairy in 2009 even though the confidence fairy turned out not to actually exist comes worrying close to “it seemed like a good idea at the time”. Especially as the economists who kept saying “watch out for the confidence fairy!” were City types talking their book and small government types grasping at any excuse to dismantle the welfare state.

    Nope, Mistake 2 was very clearly a mistake – a politically motivated one. But your point that a non-independent central bank would be even more prone to politically motivated mistakes is fair enough.

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